When a prominent investment banker recently predicted another 300 banks would fail from wounds inflicted during the financial crisis, some investors in trust-preferred securities hailed his comments as good news.
The positive reaction to an arguably dire number is a reminder of the low expectations investors and analysts once had for trust-preferred collateralized debt obligations, as well as how dicey a proposition they remain. Prices are still distressed. Ratings wildly diverge in some cases. And the recovery of the securities' collateral is, at least in part, dependent on the leniency of regulators and the M&A appetites of healthier banks and private-equity investors.
But the market has calmed to some degree, with legal challenges petering out, the stream of defaults and deferrals slowing and the market for the securities becoming a little more active. Though bank trust-preferred CDOs are still a disaster for their original investors, among them many of the small and midsize banks that fed them with debt, they garner better prices and are easier to dispose of than they were a year ago.
"Last year, a lot of the buyers were distressed funds willing to take big gambles for high yields," said Elton Wells, head of the structured products group at SecondMarket, a firm the connects buyers and sellers in illiquid markets. "Now it's mainstream funds, and we're actually seeing some of the regional midsize banks looking to buy some of these. They know the space, obviously."
Trust-preferred CDOs, generally composed of securities issued by smaller banks for which independent capital raises would be uneconomical, grew rapidly in the first half of the last decade. For only a few hundred basis points above the London interbank offered rate, community institutions could issue debt on which payments were deferrable for up to five years. Ratings agencies and investors smiled on the senior tranches of such pooled securities, which were viewed as safe due to the geographic diversity of their component banks. As the market grew comfortable with the product, many small and midsize banking companies started buying the top-rated securities themselves — even as the buffer of subordinate securities protecting those positions began to shrink.
When the crash came, some of the very traits that were supposed to guarantee trust-preferred securities' stability made them a nightmare to sort out. The diversity of the debt included in them meant that evaluating the collateral required tracking the health of dozens of small institutions, and the structure of the deals prompted infighting among some junior and senior investors. In one case, the hedge fund TPG Credit Management LP bargained with junior debtholders to buy performing collateral out of a trust-preferred CDO named Tropic IV — touching off litigation with senior investors who deemed it a raid.
With banks able to defer payment on their securities without defaulting, ratings agencies and trust-preferred holders struggled to determine what portion of deferring banks were at death's door and what portion were playing it safe by temporarily holding onto cash. Adding to the uncertainty, some banks offered to buy their debt back from trust-preferred CDOs at pennies on the dollar.
Disputes ensued, with a handful of hedge fund investors maneuvering to block discounted repurchases and both sides pressuring trustees. In one of the more memorable, and public, battles, the activist investor Hildene Capital broke up a coalition of CDO investors willing to accept 20 cents on the dollar for BankAtlantic Bancorp securities — at which point BankAtlantic raised its offer to 60 cents.
Hildene didn't budge.
"That tells me they're able to pay par," Brett Jefferson, Hildene's founder and chief investment officer, told American Banker at the time. "And they're going to, or they're going to fail."
Hildene, along with a handful of similar funds committed to maintaining the composition of the securities' collateral, appears to have won. Most of the banks seeking trust-preferred CDO discounts as part of recapitalization, including BankAtlantic, have dropped their demands, and on Dec. 20, TPG notified the judge handling the Tropic litigation that it had dropped its claim to the CDO collateral.
Barring the return of such maneuvering, how trust-preferreds fare will rest largely on the original issuers' survival. On that front, the news is, if not yet good, better than it was. According to Fitch Ratings' latest CDO default and deferral index, new deferrals are slowing. Through the first 11 months of the year, 161 banks ceased making payments on their collateralized debt, compared with 246 in the same period the year before.
The bigger question is what portion of already deferring banks ultimately are able to return to paying status. And on that front there's room for cautious optimism. Twelve deferring banks had cured through Nov. 30, compared with just two in all of 2009. Some ratings agencies are forecasting that overwhelming portions of deferring collateral will default, but continued improvement as a result of mergers, recapitalizations and a light hand by the Federal Deposit Insurance Corp. could produce better-than-anticipated recoveries.
An example as good as any is that of Hawaii-based Capital Pacific Financial Corp. in Hawaii, a deferring institution which reported to the Securities and Exchange Commission on Dec. 20 that it had reached an agreement with the Carlyle Group and Anchorage Capital for $196 million of capital. Even if it takes a while for the company to return to paying status, the outlook for the $105 million of securities it issued into various CDOs is now markedly better.
Perhaps as a result of such precedents, pricing has improved, though the change has been gradual. Wells noted the example of a bank SecondMarket helped sell a trust-preferred CDO portfolio earlier this month. Though the client's senior debt linked to various deals still sold at a significant discount to par — around 65 cents on the dollar — the prices for more junior securities were in some cases 50% or more than a year earlier.
Improving bank balance sheets, Wells said, were also making it easier for banks to offload their holdings without being forced to take unacceptably large writedowns. That, combined with at least modest improvements in price, Wells said, leads him to expect next year will see many banks exiting their trust-preferred holdings, and associated regulatory capital burdens, with lower losses than once forecast.
"It seems like 2011 might be better than people anticipated," he said.
